‘The Market?’ Which Market? Alternative Theories of Demand and Supply

Is it really feasible that there can be a single theory of ‘the market’ that encapsulates everything from tomatoes to CEOs to houses? Engineers do not think they can apply the same theory to every fluid, and similarly, it is not unreasonable to suggest markets might function very differently depending on what is being bought and sold. In this post, I’ll set out a couple of alternative interpretations of supply and demand for different markets. I developed these alternative approaches based on some well known real world observations.

A few caveats:

(1) I am not interested in deriving these schedules ‘rigorously’ from arbitrary axioms about individual behaviour. Such an approach is unnecessary as phenomena may be emergent, and it always seems to run into problems.

(2) These models should really only be interpreted as working for individual markets on a small scale, as large scale feedback effects render this type of analysis irrelevant.

(3) I am aware that there is no such thing as a demand or supply ‘curve’ in reality. Perhaps the fact that I feel the need to reduce everything to intersecting lines is a testament to how much neoclassical economics has polluted my thought. I am undecided as to whether I regard the supply-demand framework as a useful tool that can be adapted in certain circumstances, or as something that needs to be done away with entirely. I’m sure heterodox readers can give me many reasons demand-supply as a concept is not worth keeping. In any case, I regard these examples as interesting, and at the very least they are a good way to take economists on on their own turf.

(4) Finally, I apologise for my drawings, which were constructed on MS Paint.

Asset Markets

It is an observed reality that asset prices and demand are often positively related, since in many cases an asset is purchased for no other reason than selling it later on at a higher price. Price increases can act a signal for later price increases, and the opposite is also true. Hence, we will posit a positively sloped demand curve for this model. This relationship will also be exponential: at low prices, the effects will be relatively small ,but as prices spiral , the effect will get larger and larger. Since the supply of assets is relatively inelastic (in the case of land, perfectly inelastic), the supply curve will be a steep upward sloping line.

From the diagram constructed based on the observations above, we can deduce a few interesting mechanics. First, there large number of demand-supply combinations for which there is no equilibrium. If demand is to the left of the supply schedule, supply will always exceed demand and prices will fall to zero. The most likely cause of this is simply that a company or industry is not performing well, although tight monetary policy could also do it. If the demand curve is to the right of the supply schedule, demand will always exceed supply and price will spiral upward indefinitely. This could be due to excessive credit expansion or misplaced expectations.

However, between these two extremes there is a potential ‘golden zone’ for which equilibria exist. In this zone I have drawn two potential demand curves: D2, which just touches the supply curve, and hence has one potential equilibria; and D3, the likes of which would be more common and would have two equilibria. The two lower equilbria, e1 and e2, are not stable. Any drop in price will result in excess supply that will drive prices down the schedule. An upward increase in price from e1 or e2 will result in excess demand that will continue to increase price in a spiral. In the case of e2, it will propel the market up to the one stable equilibrium: e3. If the price increases, supply will exceed demand and it will quickly fall back to e3. If it decreases, demand will exceed supply, the price will rise and the market will again tend toward e3.

The volatile behaviour displayed by most outcomes in this model is in accordance with much real world experience in the stock market, from the downward spiral of Facebook to the internet stock bubble and other frequent historical experiences. But what about e3? Is it the case that certain firms or industries exhibit relatively high, consistent returns? In fact, relatively stable share prices do exist for some firms and industries: ones that are rarely hit by volatility. Insurance, transport and many consumption goods are all stable industries. Obviously this doesn’t protect them completely: firms, industries or the market as a whole may exhibit relative tranquility before something knocks them over the precipice.

We can draw a few policy conclusions from this framework. There is scope for a central bank to reduce or increase the liquidity of the system in order to try and knock the market into the ‘golden zone.’ The effects of an FTT are indeterminant, which is actually the only conclusion I can garner from the available evidence. However, the primary conclusion I would come to – which admittedly doesn’t flow completely from the model – is that due to the level of volatility, the trading day could be be extremely limited, or trade could be cut off if prices are rising or falling too fast. This way the price spirals can be curbed while the central bank adjust liquidity, and investors and funds adjust their positions, trying to shift the demand curve back into the golden zone (though I am willing to admit the last part verges on a spurious level of precision).

Labour Markets

Another market that would be expected to diverge strongly from the ‘norm’ would be the labour market. Many aspects of labour make it different to other markets: it is required to subsist; it cannot be separated from a person; it is difficult to determine the productivity of potential applicants, or even present workers; time spent in work is related to leisure time. Below I’ll outline two alternative approaches (that are also somewhat compatible).

A more comprehensive approach to labour supply, which takes into account the need for subsistence, has been provided by Robert Prasch (whose book, which inspired this post, is recommended). His approach is illustrated in the diagram below:

This can be seen as an adaption of the typical ‘backward bending‘ labour supply curve found in economics textbooks. The subsistence frontier shows the total pay required to subsist at various wage levels, whether that is interpreted as literal subsistence or a conventional and socially acceptable level of income. Obviously, the higher the wage, the fewer hours required to work to reach subsistence.

Equilibrium C is unstable as either side of it creates a wage spiral toward the next equilibrium. If the wage decreases, the labour supply will be forthcoming as workers seek subsistence level pay. At Wu they hit the limit of how long they can work and give up, settling for a ‘poverty trap’ wage at D. If the wage increases above C, wages become less necessary for subsistence and workers will withdraw their labour while remaining on the subsistence frontier. Once the subsistence frontier becomes a distant memory and wages are high enough, workers will be willing to devote more time to work in order to purchase more goods and services.

The highest equilibrium, A, is also unstable. Should the wage deviate upward, there will be a resultant upward spiral as demand always exceeds supply. Should it be reduced or capped, the wages will settle down toward a lower level. This is consistent with the observed behaviour of CEO, footballer and celebrity pay in recent decades, which shot up when marginal tax rates were significantly reduced (and a direct cap on footballer’s wages was lifted).

Clearly, a couple of evil communist interventions can be proposed based on this framework. The first is a minimum wage at or above Wc to boost the market into the desirable area. The second is steeply progressive taxation above Wa to prevent pay from spiraling Such interventions would help to enhance labour market stability, equality and reduce poverty.

I have also constructed an alternative model of the labour market. My model is shown in the diagram below and illustrates what a labour curve might look if we included the assumption of the ‘conventional’ working day/week which characterises so many people’s lives. This may be enforced legally, by social norms, or by the power of capital of labour. Whatever the cause, it is an undeniable empirical reality.

This model of labour supply could perhaps be interpreted as an elaboration or magnification of the zone between Ws and Wh on the S-shaped labour supply diagram: that is, what happens once wages reach an acceptable level. In fact, I adapted the model from one found in Arthur Lewis’ 1972 paper (p. 10) on unlimited labour, which focuses on a wage given at a conventional level. This is compatible with the above diagram.

However, I don’t wish to stretch the comparisons, as this model can also be thought of in isolation. The point is that a worker will accept work at any ‘reasonable wage’ up to a certain amount of hours – I have suggested 40, which is the norm in most developed countries. After this point the time they have normalised as leisure time is far more valuable and they expect to be paid more at an increasing rate. Eventually, they reach the physical limit of work and the effective wage must be infinite to induce labour. There are multiple equilibria if the demand curve crosses the feasible wage zone, but only one if it moves beyond it.

There are a couple of conclusions we can draw from this model. The first is that a tax on labour will not alter the amount of labour supplied if the tax + the wage is within the ‘feasible wage zone.’ In fact, empirical evidence suggests the effect of income taxation on labour supply is negligible at most (though higher for women – perhaps this analysis only applies to primary earners). Second, an increase in demand need not increase wage inflation up to a certain point, provided there are labourers willing to work within a given wage range. Past this point, an increase in demand will cause a wage-price spiral. It’s harder to verify this point empirically, although it seems consistent with the frequently observed point that inflation isn’t a problem when unemployment is high (having said that, it’s by no means the only model that predicts this).

I think a pluralistic approach such as this would be interesting. It would not be wedded to any particular model, and the task of economists would be deciding which model to apply or devising alternative models to deal with a situation. In fairness, DSGE is characterised by this approach, so it would be unfair to suggest economists do not use it at all. Nevertheless, this calls into question the rigid supply-demand framework that pervades much policy discussion of price controls, taxation and various other ‘interventions,’ and the catch-all arguments made by some economists against them.

“I am undecided as to whether I regard the supply-demand framework as a useful tool that can be adapted in certain circumstances, or as something that needs to be done away with entirely.”

Yes it is useful.

John Hicks wrote a nice book “A Market Theory Of Money” in 1989. Here is from Chapter 1 named “Supply And Demand?” on how to create a dynamic Keynesian theory of determination of national income and expenditure and the connection to inventories. This was also the view of Kaldor from 1939 and such a thing is used in Godley/Lavoie.

“… The traditional view that market price is, at least in some way, determined by an equation of demand and supply had now to be given up. If demand and supply are interpreted, as had formerly seemed to be sufficient, as flow demands and supplies coming from outsiders, it is no longer true that there is any tendency over any particular period, for them to be equalized: a difference between them, if it were not too large, could be matched by a change in stocks. It is of course true that if no distinction is made between demand from stockholders and demand from outside the market, demand and supply in that inclusive sense must be equal. But that equation is vacuous. It cannot be used to determine price, in Walras’ or Marshall’s manner. For what matters to the stockholder is the stock that he is holding: the increment in that stock, during a period is the difference between what is held at the end and what was held at the beginning, and the beginning stock is carried over from the past. So the demand-supply equation can only be used in a recursive manner, to determine a sequence (It is a difference or a differential equation); it cannot be used directly to determine price, as Walras and Marshall had used it.”

“Second, an increase in demand need not increase wage inflation up to a certain point, provided there are labourers willing to work within a given wage range. Past this point, an increase in demand will cause a wage-price spiral.”

Given that labor costs are only a part of the costs of goods and services, shouldn’t we expect wage-price spirals to converge?

OK. Let’s start with wage inflation. Suppose that wages are 25% of the employer’s costs. Suppose wages increase by, say, 5%. That means that costs increase by 1.25%. My father was a retailer, and as a rule of thumb, he set initial prices proportionally to costs. Assuming that those prices worked, prices would increase by 1.25%.

Now let’s suppose that such increases were general. Workers, then, might want additional wage increases of 1.25% to meet price inflation. Say that they get it. Suppose that other costs besides labor would generally increase by 1.25%, so now, assuming price increases followed proportionally, we have an increase in inflation of 1.25%, not 5%.

However, having gotten a 5% increase in wages, workers might not feel the need to get an additional 1.25%, because they could afford the new prices. They might only want, say, a further wage increase of 1% or less. If that pattern continues, at each iteration inflation will drop, converging towards 0, except as other factors are at work.

Suppose, however, that we start with price inflation, with the workers playing catch-up. Then at each iteration the workers will be playing catch-up, and the initial price inflation will tend to persist.

There is a flaw in that 5%/1.25% idea.
It may be that wages make up only 25% of employers’ costs, but why do the remaining inputs cost anything? Reason is that labour and machinery and materials are needed for their production. And why do the latter machinery and materials cost anything? Same reason.
In short, near 100% of the cost of everying is attributable to wages – well “wages” in the broadest sense of the word: that’s counting profits as the employers “wage”.
To be more accurate, GDP can be split into wages, profits, rent and interest, with wages taking the lion’s share. So a 5% wage increase will quickly result in very roughly a 4% price increase. But my guess is that profits, rent and interest will quickly catch up, with the result being that a 5% all round wage increase will result in a 5% price increase near enough.

Fair point, although major corporations have control over the prices of their inputs and wages so they may be able to quell this process.

It reminds me of Galbraith’s argument that blaming unions for wage price spirals misses the point that, if corporations could have afforded to raise prices, they would have been able to regardless of their wage costs, and since they are the ones who actually raise prices, it doesn’t make sense to blame unions.

I assume the curves are meant to be for aggregate demand and supply of labor for the whole economy, right ?

At stable equilibrium D workers are working very long hours for low wages, What is happening to the output they produce ?

I can think 2 options.

1, Assuming cost+markup model then prices are also low at D and workers are actually better off at D than implied in the model. assuming prices are a fixed markup on costs then the various equilibrium are likely just points on the supply of labor curve where workers are indifferent between wages and leisure.

2. Evil capitalists are making big profits (presumably by selling goods to each other). The profits at this equilibrium are clearly higher than those at the lower-wage equilibrium. Seeing those big profits wouldn’t you expect new capitalists to arrive and bid wages up again to the lower levels of profits seen higher up the curve ?

I assume the curves are meant to be for aggregate demand and supply of labor for the whole economy, right ?

No. As I commented, this type of analysis becomes contradictory once feedback effects are large enough. The model could be thought of as a series of ‘zones’ based on different types of workers in a certain industry. Only the unskilled will find themselves at the bottom (in absence of major corporate/state interventions to the contrary).

The model is one of real wages so the concerns about price are misplaced.

2. Evil capitalists are making big profits (presumably by selling goods to each other). The profits at this equilibrium are clearly higher than those at the lower-wage equilibrium. Seeing those big profits wouldn’t you expect new capitalists to arrive and bid wages up again to the lower levels of profits seen higher up the curve ?

This would represent a shift in the demand curve. As you can see, it would bid the equilibrium up slightly but it would have to be major to have a real impact.

Do these models have an implicit assumptions of mark up prices ? (ie that the lower the wage rate the lower the sales prices ?). if so, then what is the mechanism that causes real wages to fall as output expands in a world of mark-up prices ?

I would say that for the purposes of the model, prices are held constant.

Bear in mind that output is the dependent variable and real wages the independent variable. We are seeing how employment varies as the wage rises and falls, ceteris paribus. What you are noticing is that if we are talking on too large a scale, the ceteris paribus assumption is bunk, and I agree. At that point this type of analysis would not hold anyway.

I can see how an individuals supply of labor curve could be shaped like this one, and even that every individuals supply curve also could. It would seem unlikely that an industries curve would be shaped in this way because in general they could attract a greater supply of labor by offering relatively higher wages. I suppose if this was a very specialized area (so raising wages would not attract new entrants) then I can see this model is theoretically possible.

I have a question on the minimum wage proposal. In theory in this model the market could indeed be guided to a higher wage by minimum wage laws. But how would the participants ever get to know of the existence of the higher wage equilibrium?

On a side issue: I think this model actually would make some sense if applied to aggregate supply and demand for labor in the whole economy, as long as one uses a more “Austrian” approach to profit (where it is derived from time and leisure preferences of market participants). I think it does not work in a world of mark-up prices where one can’t explain the relationship between real wages and output at the different equilibrium. I would welcome your thoughts on this.

I suppose if this was a very specialized area (so raising wages would not attract new entrants) then I can see this model is theoretically possible.

Raising wages attracts new entrants until people cannot physically work any more. During the low wage period workers will work up to subsistence then prefer leisure. However, once wages hit a certain level workers will start to prefer more income above subsistence level to their leisure time until they reach satiation. Then the supply curve reverses again.

I have a question on the minimum wage proposal. In theory in this model the market could indeed be guided to a higher wage by minimum wage laws. But how would the participants ever get to know of the existence of the higher wage equilibrium?

I’m afraid I don’t understand the question. The mechanics of the market will push it toward equilibrium if certain wages are banned.

On a side issue: I think this model actually would make some sense if applied to aggregate supply and demand for labor in the whole economy, as long as one uses a more “Austrian” approach to profit (where it is derived from time and leisure preferences of market participants). I think it does not work in a world of mark-up prices where one can’t explain the relationship between real wages and output at the different equilibrium. I would welcome your thoughts on this.

Are are you saying that ‘profit’ decisions in this model would be highly analogous to decisions made by labourers and hence could be included?

On “Raising wages attracts new entrants until people cannot physically work any more”

My point is that for an industry where in the medium term new workers could be trained up then I see no reason why the supply curve would bend backwards – even if existing workers started to prefer leisure new workers could be attracted (assuming wages elsewhere were not rising).

On the minimum wage thing: My point is that participants do not generally know the shape of the curve they are on. At point D how could the govt or anyone else could know that a minimum wage (at WS) would lead to a new and higher equilibrium rather than just a lot of unemployment in that industry if the supply curve was a standard shape and the minimum wage just had the effect of setting it above the prevailing single equilibrium.

On profits: I think I am still struggling to see how the relationship between wages and prices works in a model where prices are assumed to be set as a mark up on cost. If this were a model of aggregate labor supply and demand then as supply of labor increases (and more output is generated) then either real wages must increase as output increases or profits have to. This seems a bit at odds with a mark-up price model where (I assume) profit rates stay reasonably constant. I know that this isn’t what the post is about (as the model is for a single industry) but if you can point me to something that explains the relationship between wages,prices and profits in a model where prices are assumed to be a a mark-up on cost it would be useful to me.

For the purposes of the model, though, the firm’s size is assumed to be roughly fixed or face a constraint. Hence, they could not keep hiring labourers indefinitely. In any cases, the supply curve is as seen from the perspective of the worker’s decisions. New workers being attracted represents a shift in demand, rather than supply.

I don’t think we disagree about the minimum wage.

On profits: I think I am still struggling to see how the relationship between wages and prices works in a model where prices are assumed to be set as a mark up on cost.

I think this can only work if prices are assumed fixed. The mechanics you identify are indeed close to contradicting the model and I have no quarrel with the idea that once you add dynamic effects, or scale up too much, this model becomes invalid and/or misleading.

‘Land’ in the Georgist sense does not mean ‘solid ground,’ but ‘the earth’s surface,’ or even more broadly the ‘space’ in ‘space time continuum.’ In this way it is fixed (except possibly at extremely large scales).

That’s an almost Einsteinian sense! I take “land” to mean a combination of “space usable to humans” and “location”. In this sense, building up, creating livable sea-borne spaces, and creating habitable space stations would all increase available land, though not by much.

You may be interested in a book I recently came across, Land Title Origins: A Tale of Force and Fraud, by Alfred Chandler, published with the approval of the Soil Conservation department of the US Department of Agriculture. As the title implies, Chandler argues that nearly all land titles originated with violence or deception, usually justified by hereditary ranks not respected by modern republics.

The Georgian meaning of ‘land’ is in fact ‘location’ and hence it holds that it is fixed. Whether somebody claims ownership of an underwater fortress or the Sahara Desert makes no difference to principle.

That sounds like an interesting read – I am aware of Chandler’s work on the organisation, which is also very good. It doesn’t surprises me that most land titles were acquired unjustly.

I would like to take a shot at the single all encompasing theory of “market”. It is a very wide theory and works based on preference for purpose, social preference for what is for.
I base the need on social organising to betterment of all (most), hence government as organiser of market, produced for democraticly elected purpose.
How to achieve the biggest benefits from market for all?
I would like to introduce term Nominal Surplus Circulation as flow of money (nominal value) that enables usage of real value (products and services). Without differentiating real from nominal value consistently troughout deduction it can not be understood.

Market is a mean to enable flow of Nominal Surplus Circulation trough diversity of prices to those that need it and want to use it for their own consumption.

Surplus here is nominal, not in Marxist sense surplus, but all money you do not use for yourself. For example in a familly income earner gives its surplus to kids which they will consume on themselves. In a city with variety of income budget contributors the surplus is given (spent in) to lower producing areas. In USA, surplus states, help deficit states consistently. In EU, surplus states spend on deficit states borrowing which flows back to surplus states trough trade, once this stops recesion breaks out in both states. In a corporation, shareholder spends his surplus on workers pay (surplus as something not spent on themselves) who buy owners products and money flows back.
If income of workers is lowered, income of owners is raised and with depositing it into a bank it enables consumer power trough debt and increasing debt trough lower interest rates enabled by higher savings of owners. It does not matter how lower income uses real value (goods and services), trough income or debt as long as it uses real value and money just flow.
No matter how rich you are, you can not use that much of real value while having excess nominal value which you lend out for someone else to use it.

Market is an organized way of constant Nominal Surplus Circulation. My spending is someone elses income = Nominal surplus Circulation

All other accounts of supply and demand is for microeconomics not for market.
Demand is what i want to use, the way of enabling that is money flow.

Market is a system of distributing goods and services trough auction, with preferences defined with goverment organizational influence as power broker. Government influences the market by power of central planing trough tax preferrence based on economic theory pervasive at the time.

Let me improve it a bit.
Market is a system of distributing goods and services trough auction, with preferences defined with goverment organizational influence as power broker with signals from the market itself. Government influences the market by power of central planing trough tax and spending preferrence based on economic theory pervasive at the time with a strong positive feedback loop.

In other words,
Market is a system of distribution of goods and services organized by government as representative of the powers from the market.

Market is a system of distributing goods and services trough auction, with preferences defined with goverment organizational influence as power broker with signals from the market itself.

This is partially true, although I’m not sure ‘auction’ is appropriate. In an auction the price is completely flexible and people bid it up from a baseline based on willingness/ability to pay. In a market prices are set by firms so that (approximately) the optimal sales/profits/market share will be obtained. Consumers can then take it or leave it.

Btw, it’s spelled ‘through.’ Not being a pedant – I guess English isn’t your first language.

Yes on both, language and auction. I apologize for my writing skill. I am acctually wery good but do not give enough time for spell check.

There is so many ways prices are set in a market, but rarely as you described as firms doing it. It is mostly government assisted price marking. Did you hear about price of milk in USA going from $3 to $7 if congress did not extend a farm bill, which they did in the end? It is like that for many things; oil, food, green cars, housing prices, health care. Only monopoly and cartel firms set their own prices.

Some things have auction set prices but some have reverse auction mechanics and some things not at all.
I think that for that to work we would need multiple definitions on price seting just as quantum physics have 4 definitions on universe.

Have you read a copy of Principles of Economics by Alfred Marshall? I own a copy of the Royal Economic Society variorum edition of Alfred Marshall’s Principles of Economics.

If you read it, you can tell that Marshall was perfectly aware of the realities of market structure, and knew that supply and demand was more nuanced than a simple pair of curves. Also, Marshall wasn’t a blind advocate of what is now commonly referred to as “perfect competition” (Marshall uses a different term in his textbook, “free competition”, but even then, he’s more nuanced than the simplified caricature makes him out to be. Dr. Michael Emmett Brady has noted that Marshall, Pigou, and Keynes seemed to be aware of informational assymetry with regard to market participants, and has stated before that Marshall, Pigou, and Keynes are best described as using “pure competition” in their economic theories…not the Chicago School reformulation of “perfect competition”, which assumes informational symmetry and complete information). Keynes and Pigou’s great teacher does list qualifications to the realities of markets.

That stated, if you read (I believe, Section II, and in particular, Chapters 8 to 10) of The Theory of Unemployment (1933) by A.C. Pigou and Book V (which consists of Chapter 19, Appendix to Chapter 19, Chapter 20, and Chapter 21) of The General Theory of Employment, Interest, and Money (1936) by J.M. Keynes, you will notice that there are similarities. Both use pure competition, for example, and both use the same level of mathematics (differential calculus and integral calculus)…

Yeah, although I haven’t actually fully read Marshal’s Principles I have come across various passages that suggest Marshall was careful about applying the neoclassical theory too broadly. For example I just finished a book called ‘The Myth of the Market Economy’ which cites passages from Marshall suggesting that economists need to pay more attention to the internal structures of firms rather than thinking of them as a ‘black box.’

You’re welcome, Unlearningecon. On another note, I believe I have e-mailed you copies of some of those articles before. Why don’t you check your e-mail to see if I have? (I’m pretty sure that I included copies of Dr. Michael Emmett Brady’s work on the maths in Keynes’s magnum opus, but just check to be sure anyway.)

Since you probably have a copy of The General Theory of Employment, Interest and Money, I’m going to ask another question instead.

When will you acquire a copy of Arthur Cecil Pigou’s The Theory of Unemployment?

You need to read it and digest it completely in order to understand the similarities and differences between Pigou’s mathematical model and Keynes’s mathematical model.